Question

This week we discuss capital budgeting methods and process. Could you apply the knowledge your learn this week to make better decisions in your personal life or professional duties? Please elaborate your answer with examples.

Any idea on what personal or professional experiences this could relate to? Just examples and why would be nice so that I can relate it to my life somehow. Thank you!

Answer 1

As we know there are many capital budgeting methods like Net present value, Adjusted present value, Break even Analysis etc.

We will consider them one by one:

1. Net present value(NPV): In this method, we initially assess and finalize future cashflows. On the basis of this, we find the free cash flow to the company. All these future cash flows are pulled to the present value at a discount rate called WACC(Weighted Average Cost of Capital). The discount rate, WACC, is found or calculated based on the beta value (Volatility), risk-free deposit rate, perceived risk, capital structure, and any other known risk factors. The value that we get after discounting is the NPV of the company. If NPV is greater than or equal to Zero means that company is at breakeven or its meeting all its obligations of both investors, promoters, and debtors.

This process can be done for any projects too, for example, if we consider a project with a cash flow of $-100, $50 and $100. Assume the discount rate is 30%. If we don't know the method we will see that the benefit is $150 and cost is just $50 and we might go ahead. But in reality, when we take the NPV of the project we get as Approx $(-)3. This means that we are losing money at the end of the day when we consider the WACC.

This is useful in personal life too. Consider that you have lend a sum of $100 to a friend. Then assume that he repays at 1st year 50 and 2nd 50. Then the value NPV @ 5%(Risk-free return rate) is $(-)7.03. This means that you are actually losing approx $7 by doing this transaction.

2. Adjusted Present Value(APV): This is similar to APV but the difference is in the discount rate. This is a modified version of NPV. In here we do not exactly use WACC. In here we had defined, Business Risk(Ka), Expectation of equity holders(Ke) and Expectation of debtors(Kd). In this method, we discount the business cash flows at business risk and all other financial benefits at Ka, Kd or Ke depending on the risk. For example in case of a tax benefit from interest and assuming the capital structure is of constant debt then, we discount the tax benefits at Kd rather than WACC as in NPV. This will slightly increaser the companies' worth and when we consider millions of dollars, this makes a huge difference.

This primarily carried out in case of company valuations for Banks, IPOs, etc. In such case the margin saved from NPV methods will constitute at an order of millions. This may account for make or break in case of fund pitching in front of a private equity(PE).

3. Break Even Analysis(BEA): In here we find the Break Even Revenue of the company. In this we have to find the fixed Cost (FC) and Variable Cost(VC) of the last year. Based on this we need to find the Break even revenue by the formula

Break-Even Revenue = (FC + TOI)/Contribution margin %
Contribution Margin % = (Revenue-VC)/Revenue

TOI - Target Operating Income

From this, we can easily get the break even point or the required TOI by substituting values. For example, if we consider a Rev of $1000, FC=$500, VC=200 we get the break even point as $ 645/-. This signifies that the company should atleast produce a Revenue of 645 to reach a no loss, no profit situation.

Now if in above example if we need a profit of $500, then after inputting values we get the Rev as $ 1250. This is a very powerful tool in the case of a company. On the basis of this value only we can prepare the targets for the marketing guys.